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Europe - May 2014
InvestmentsMay 6 2014

What is the extent of the global recovery?

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There have been plenty of surprises in the markets since January, with longer-dated bonds and commodities performing better than expected, and equities struggling to move forward, especially in the US and Japan.

But if you step back from the volatility, expectations of a moderate, more synchronised global recovery in 2014 remain on track.

In the latest JPMorgan Guide to the Markets it is calculated that more than 85 per cent of countries were in expansionary mode for the first three months of 2014, with a positive PMI of 50 or more.

The US Federal Reserve (Fed) clearly believes the US recovery is on track. Though extreme weather at the start of the year made the data difficult to read, it has continued to ‘taper’ its asset purchases each month, injecting less and less money into the US economy via quantitative easing.

Talk of tapering helped raise 10-year Treasury yields by more than one percentage point in 2013. But actual tapering has not produced any rise at all. Why?

Part of the reason is that investors have grasped that “tapering is not tightening”. As long as the Fed is buying bonds it is expanding its balance sheet, and as long as it is expanding its balance sheet, monetary policy is getting looser.

Another key point for fixed income investors to bear in mind is that global liquidity conditions are not only set by the Fed. Of the other three key central banks in the developed world, only one – the Bank of England – is expected to raise interest rates in 2015, on a similar timeframe to the US. The other two are either loosening or keeping policy where it is.

With a still-tepid rate of growth and inflation falling well below target, the European Central Bank (ECB) is not expected to tighten policy in the foreseeable future. If it acts in 2014 it will be in the direction of further loosening. In Japan, ‘Abenomics’ suggests the Bank of Japan is going to keep expanding its balance sheet dramatically to push down the currency and create inflation.

Bottom line: the recovery remains on track but there is still ample global liquidity, and likely to be for a considerable time.

The large amounts of cash sitting on household and company balance sheets are a reminder that the world is still a lot more risk-averse than it was before the crisis. In that kind of environment, it pays to be a risk taker. But investing in risk assets – particularly equity markets in Europe and the US – is unlikely to pay as well as it did in 2012 and 2013, when investors were much more nervous, and equities looked cheap on most standard valuation measures.

Today, both the US and Europe look close to fair value, or even slightly above it. That does not mean sentiment is about to crumble. Instead, it means stock selection is getting more important, because further growth in prices is likely to relate more to fundamental drivers like earnings and margins.

The takeaway for fixed income investors is equally nuanced. If the basic recovery story remains intact, we can expect longer-dated bond yields to creep up, at least in the UK and the US, causing losses for holders. Economic fundamentals will be important here, too, because policymakers in both countries have made clear the timing of official rate rises will continue to be ‘data dependent’.

If the US and UK recoveries remain on track, the likely divergence in policy between the US and the eurozone suggests some opportunities for fixed income investors to protect returns by diversifying their holdings.

Within fixed income, investors can also broaden the mix to include high yield bonds and other assets capable of showing positive returns in a rising rate environment.

But investors should remember that the world is still a very long way from normal. By my calculation, output in the developed world is more than 9 per cent lower than it would be had countries simply continued on their long-term trend after 2007. We know the global economy is getting better. The key concern for policymakers is whether it can grow fast enough to make a serious dent on that lost output.

Whether it’s the likely path of interest rates, the risk of inflation, or the long-term return on developed market equities going forward, the answer to many of the questions central banks are facing will depend – in no small measure – on how much of that lost capacity the world gets back.

What investors should be asking themselves in 2014 and 2015 is not whether we have a global economic recovery, but by how much it is going to recover.

Stephanie Flanders is chief market strategist for the UK and Europe at JPMorgan Asset Management